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Chapter 20

Item Item Item Etc.

International Adjustment and Interdependence

McGraw-Hill/Irwin Macroeconomics, 10e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 20-2

Introduction

Countries are interdependent

Booms or recessions in one country spill over to other countries through trade flows Changes in interest rates in any major country cause immediate exchange or interest rate movements in other countries

In this chapter we explore the issues of international interdependence further:

through which a country with a fixed exchange rate adjusts to balance of payments problems  Aspects of behavior of the current flexible exchange rate system
 Mechanisms

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Adjustment Under Fixed Exchange Rates

Adjustment to a balance-of-payments problem can be achieved in two ways:

 Change

in economic policy

Monetary policy Fiscal policy Tariffs Devaluations

 Automatic

adjustment mechanisms

Money supply p spending Unemployment p wages and prices p competitiveness

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The Role of Prices in the Open Economy

The real exchange rate is expressed as:

R! ePf P
(1)
p assume that exchange rate and foreign prices are given

How does the openness of the economy affect the aggregate demand curve?
 An


increase in the price level reduces demand

Higher price level implies lower real balances, higher interest rates, and reduced spending  Given the exchange rate, our goods are more expensive to foreigners and their goods are relatively cheaper for us to buy p exports decrease and imports increase
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The Role of Prices in the Open Economy

Figure 20-1 shows the downward sloping AD curve where AD | DS  NX and the NX = 0 curve At point E the home country has a trade deficit

[Insert Figure 20-1 here]

To achieve trade balance equilibrium, we would have to Become more competitive (exporting more and importing less) Reduce our level of income in order to reduce import spending
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The Role of Prices in the Open Economy

What should the country do? The central bank could use its reserves to finance temporary imbalances of payments Can borrow foreign currencies abroad

[Insert Figure 20-1 here]

May be troublesome if the countrys ability to repay the debt is in question

p Country

must find a way of adjusting the deficit

Cannot maintain and finance current account deficits indefinitely or for long periods of time
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The Role of Prices in the Open Economy

Automatic adjustment When the central bank sells foreign exchange, it reduces domestic high powered money and the money stock

[Insert Figure 20-1 here]

The deficit at E implies the central bank is pegging the exchange rate, selling foreign exchange to keep the exchange rate from depreciating Over time the AD schedule, which is drawn for a given money supply, will be shifting downward and to the left
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The Role of Prices in the Open Economy

Automatic adjustment Point E is also a point of unemployment

[Insert Figure 20-1 here]

Unemployment leads to declines in wages and costs Over time, the SR equilibrium point, E, moves downward as the AS and AD shift Process continues until reach point E

Point E is a LR equilibrium point and there is no need for exchange market equilibrium p automatic adjustment
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Policies to Restore Balance

The classical adjustment process may take time p alternative is policies to restore external balance

Because of their side effects, policies to restore external balance must generally be combined with policies to achieve full employment
Policies to create employment will typically worsen the external balance  Policies to create a trade surplus will affect employment


Necessary to combine expenditure-switching policies, which shift demand between domestic and imported goods, and expenditurereducing/increasing policies in order to cope with the two targets of internal balance and external balance.
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Policies to Restore Balance

Can use policies to reduce aggregate demand p expenditure reducing policies

The trade deficit is expressed as NX | Y  (C  I  G) (2)

A balance-of-trade deficit can be reduced by reducing spending (C+I+G) relative to income through restrictive monetary and/or fiscal policy

The link between the external deficit and budget deficits is | (S  I )  [TA (G  TR)] (2a) shown in equation (2a):

If S and I are constant, changes in the budget would translate one for one into changes in the external balance Budget cutting would bring about equal changes in the external deficit p but budget cutting will affect S and I, thus need a more complete model to explain how budget cuts affect external balance
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Devaluation

The unemployment that accompanies automatic adjustment suggests the need for an alternative policy for restoring internal and external balance The major policy instrument for dealing with payment deficits is devaluation = an increase in the domestic currency price of foreign exchange

Given the nominal prices in the two countries, devaluation:

Increases the relative price of imported goods in the devaluing country  Reduces the relative price of exports from the devaluing country


Devaluation is primarily an expenditure switching policy.

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Exchange Rates and Prices

The price level typically changes with the exchange rate (including after a devaluation) The essential issue when a country devalues is whether it can achieve a real devaluation
A

real devaluation occurs when it reduces the price of the countrys own goods relative to the price of foreign goods  Using the definition of the real exchange rate:

R!
pA

ePf P

real devaluation occurs when e/P rises or when the exchange rate increases by more than the price level
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The Monetary Approach to the Balance of Payments

There is a link between the money supply and the external balance p the adjustment process must ultimately lead to the right money stock so that external payments will be in balance The only way the adjustment process can be suspended is through sterilization operations

Central banks frequently offset the impact of foreign exchange market intervention on the money supply through OMO A deficit country that is selling foreign exchange and correspondingly reducing its money supply may offset this reduction by open market purchases of bonds that restore the money supply STERILIZATION Persistent deficits are possible p CB actively maintaining the stock of money too high for external balance

STERILIZATION
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Interest Differentials and Exchange Rate Expectations

In our model of exchange rate determination international capital mobility was assumed

[Insert Figure 20-9 here]

When capital markets are sufficiently integrated, we expect interest rates to be equated across countries

Figure 20-9 shows the U.S. federal funds rate and the money market rate in Germany

These rates are not equal How do we square this fact with our theory?
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Exchange Rate Expectations

Have assumed that capital flows internationally in response to nominal interest differentials

Theory is incomplete when exchange rates can and are expected to change Must extend our analysis to incorporate expectations of exchange rate changes

Total return on foreign bonds measured in our currency is the interest rate on the foreign currency plus whatever earned from the appreciation of the foreign currency, OR (5) i f  (e e
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Exchange Rate Expectations

Investor does not know at the time of investment how much the exchange rate will change

The term (e e should be interpreted as the expected change in the exchange rate Net capital flows are governed by the difference between our interest rate and the foreign rate adjusted for expected depreciation: i  i f  (e e The balance of payments equation is: ePf (e (6) BP ! NX Y ,  CF i  i f  P e
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The balance of payments equation needs to be modified

Exchange Rate Expectations

The adjustment for exchange rate expectations thus accounts for international differences in interest rates that persist even when capital is freely mobile among countries

When capital is completely mobile, we expect interest rates to be equalized, after adjusting for expected depreciation:

i ! i f  (e (6a) e Expected depreciation helps account for differences in interest rates among low and high-inflation countries

When inflation in a country is high, its exchange rate is expected to depreciate and nominal interest rates will be high
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